July 14th, 2010 14:32 EST
A Cruise Control Investment Hedging Strategy
The first page of search engine research tells you that: "Investors use hedging strategies when they are unsure of what the market will do"--- isn`t that always the case? Further along you learn that there are many different kinds of strategies, nearly all of which rely upon some sort of derivative betting mechanism.
But what is hedging all about in the first place?
Conspiracy theorists have their hands in the air. What`s that? Portfolio hedging strategies were created to expand the market for the first generation of derivative products--- options and futures contracts. Hmmm, not so far fetched an idea, really. Just back up a bit and think about what they are trying to accomplish.
Hedges are designed to massage your market value numbers, a kind of security blanket that softens the highs and lows of the market cycle. But why focus on the fluff of transient market values in the first place? Cycles eventually correct themselves without the unnecessary drama, guesswork, risk, and trading fees.
It`s not the market value of the portfolio that is of primary importance. It`s the actual content of the portfolio and how you deal with the natural dynamics of the securities you own. Why can`t the media reinforce that kind of stuff instead of the emotion of the month?
If a portfolio has a semi-guaranteed "base income" of 4%, a 4% cushion (or hedge) is always in place, one that grows annually with proper asset allocation management, and adds to the market value in upward cycles--- nah, too simple.
Once upon a time (long before Quants, Swaps, and million dollar bonuses) investors knew that they could not know "what the market will do"--- in direction, duration, range, or vacillation. They recognized that neither humans nor human created machines could predict the future with any degree of accuracy. So they learned how to deal with uncertainty.
They recognized the cyclical nature of the major variables that moved the market cycle, and they developed a strategy that actually worked for decades. Long-term investors navigated the peaks and troughs of the market cycle with the now obsolete, eyes wide shut, buy-and-hold approach.
This dinosaur lost its potency as soon as the markets became accessible to virtually everyone--- professional investors, custodians, and trustees (in the old days) understood investing, risk vs. reward thinking, diversification, fundamental analysis, and income generation.
Those safer "good old days" are gone.
Cultural changes, the need for instant gratification, the paramutual, product mentality of the modern investment arena, and the growth of the financial services industry brought fast and furious directional change that undermined the safety of the playing field.
Today`s unprepared (but well-heeled masses) are quick to accept the candy-coated, easy to own and abuse, gambling chips distributed by the Wall Street gaming institutions and blessed by their over-lobbied senatorial henchmen.
Unfortunately, trustees, custodians, and sales professionals` job preservation instincts led them to the dark side as well.
Most people paint themselves into a market-value-only-assessment corner by investing in multi-security products and by ignoring the all-important income bucket of their portfolios. Wall Street propaganda doesn`t allow investors to focus on anything but market value, creating the need for "protective" hedging techniques.
But what do these phony insurance policies promise, and what do they actually protect?
The lack of education and general unpreparedness of newly enabled investors opens the doors for all forms of schemes, scams, techniques and hedges --- all designed to limit the bottom line impact of perfectly natural market forces.
Why do we jump through all of these "prevent-defense" hoops? Because we just don`t know how or have the patience to design and manage a classic, safer, plain vanilla, stocks and bonds portfolio. The market cycle is the favorite son of the investment gods. You either make it your friend or fail as an investor!
The ultimate investment portfolio hedging strategy is one that only requires simple to understand investment techniques like the portfolio income "hedge" described above--- part of the Working Capital Model`s QDI, and the centerpiece of the Market Cycle Investment Management methodology.
The other two features of this approach (one that has guided its users through, around, and over the three financial meltdowns of the past 40 years) are explained briefly below. The "I" in QDI is for income.
"Q" is for quality. If you study the long-term behavior of Investment Grade Value Stocks, and high quality income CEFs, you`ll discover that they hedge themselves more effectively than any artificial mechanism ever could.
Take a look at their histories, put a hypothetical $100 in each whenever they fall 20% from their 52-week high, and sell them when they produce a 10% profit. How many millions would you be worth today?
"D" is for diversification. Absolutely never allow any position in your portfolio to exceed 5% of total portfolio working capital (i.e., the total cost basis) and never start a position anywhere near maximum exposure.
Be honest now, how many losses would you have reduced, and how many profits would you have pocketed had you respected the QDI?
Put your investment portfolios on cruise control, with a hedging strategy approved by the investment gods.
Professional Portfolio Management since 1979
Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read"